A report issued Tuesday by the Securities and Exchange Commission makes that case that new legislation, audited financial statements, and increased Commission oversight are needed to improve the municipal securities market and enhance disclosures for investors.

At the start of 2012, there were more than one million different municipal bonds outstanding totaling $3.7 trillion, with 75 percent held by retail investors either directly or indirectly through mutual, money market, closed-end, and exchange-traded funds. There were nearly 44,000 state and local issuers.

According to the new report, this market has not been subject to the same level of regulation as other sectors of the U.S. capital markets “due to broad exemptions under federal securities laws for municipal securities.” Without a statutory regime for municipal securities regulation, the SEC's investor protection efforts in the municipal securities market have been limited.

“Historically, municipal securities have had significantly lower rates of default than corporate and foreign government bonds,” it says. “Nevertheless, municipal bonds can and do default, and these defaults can negatively impact investors in ways other than non-payment, including delayed payments and pricing disruptions."

A majority of defaults in the municipal securities market are in conduit revenue bonds issued for non-governmental purposes, such as housing projects, hospitals, nursing homes, and industrial development bonds used as an economic development tool, according to the report.

In May 2010, Commissioner Elisse Walter was tasked by Chairman Mary Schapiro to lead an effort to examine the issue. The resulting report, released on July 31, proposes legislative changes, among them that Congress authorize the SEC to set baseline disclosure standards and require municipal issuers to have audited financial statements.

Other legislation the Commission wants Congress to consider:

Aligning conduit borrowers that are not municipal entities with non-governmental borrowers in terms of registration and disclosure standards since they are private entities financing non-governmental private projects.

Authorizing the SEC to establish the form and content of financial statements for issuers of municipal securities, and to recognize a designated private-sector body that would set industry standards.

Conditionally providing a safe harbor from private liability for forward-looking statements of repeat municipal issuers.

Allowing the Internal Revenue Service to share information with the SEC that it obtains from returns, audits, and examinations related to municipal securities offerings, particularly in instances of suspected fraud.

Providing a mechanism, through trustees or other entities, to enforce compliance with continuing disclosure agreements and other obligations intended to protect bondholders.

The report also pitches potential rulemaking by the SEC or Municipal Securities Rulemaking Board. Among the areas that could be addressed: disclosure issues, including the timing and content of financial information; disclosures relating to pension and other post-employment benefit plans; and derivatives use by issuers and obligated persons, and conflicts of interest including pay-to-play practices.

Other recommendations relate to pre- and post-trade transparency, including ways to give retail investors better access to pricing information.